Sorting the Good Guys from Bad: On the Optimality of Deterministic Audit with Ex-Ante Information Acquisition

Research output: Working paper

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DatePublished - 2012
PublisherCSEF Working Papers
Original languageEnglish
ISBN (Electronic) http://www.csef.it/WP/wp201.pdf

Abstract

In a costly state verification setup, a principal entering a contract with an ex-post informed agent, as well as auditing, has the option of acquiring costly imperfect information about future revenues either before or after the contract is agreed. If acquired, information immediately becomes public. We find that it may be optimal to gather information either for sure or randomly but only after the contract. When acquired, information improves targeting of audit reducing the inefficiencies associated with it. This is obtained by auditing deterministically after favourable signal realisations and never after unfavourable ones. When no signal is collected as a result of randomisation in information acquisition, audits either occur deterministically or never, depending on whether the principal breaks even upon signal acquisition. Interpreted in the context of tax auditing, the results provide a rationale for the tax agencies widespread reliance on presumptive taxation methods.

Bibliographical note

Now accepted for publication in Economic theory DOI 10.1007/s00199-014-0818-y

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